Mortgages, Down Payments, and Real Estate Amnesia

This article from the front page of the New York Times business section reminds me how quickly we sometimes forget our past mistakes. The article focuses on a young couple and their new home—the the real story is in how they paid for it. This paragraph is what really caught my attention:

“But instead of making a traditional down payment of 20 percent — the magic amount often needed to avoid the added cost of mortgage insurance — they put down just 10 percent, still a significant sum, on their $685,000 house. Yet they managed to circumvent the insurance, saving more than $250 a month. How did they do it? They took out one loan equal to 80 percent of the purchase price, and another loan for 10 percent — something that has traditionally been called a piggyback loan or a second mortgage.”

Make no mistake about it, this is an an ominous development.

During the last housing bubble piggyback loans were commonly available as what were known as “80/20s”. An 80/20 is a two-loan package where a homebuyer gets a first mortgage for 80% of the purchase price of a home while simultaneously taking out out a second mortgage (or a HELOC) to count as a 20% down payment. While this financial two-step relieves the homebuyer of the cost of private mortgage insurance (which is generally required when borrowers are financing more than 80% of the home’s price) it also exposes the homebuyer to a level of financial risk that can quickly become untenable if the economy takes a downturn.

The details of this story remind me of the financial behavior we saw leading up to the housing crisis of 2006—2007. Strategies like the piggyback loan are short-sided and are part of a toxic mix of financial tricks that not only weaken the real estate market, but also conspire to erode the foundation of our entire economy. Why would we revive them? Have we not learned our lesson?

It is also worth mentioning that the precept of a 20% downpayment is not simply a “magic” number—it is an economically sound, time-tested figure that allows homeowners a buffer of equity that can protect against short-term economic crisis or falling home values. Generally speaking, as long as there’s equity in a transaction there’s less likelihood of default or financial disaster/problems. The article points this out:

“The 20 percent down payment requirement is etched into the charters of both Fannie Mae and Freddie Mac, which back or purchase most mortgages in the United States up to $417,000 (or $625,500 in higher-cost areas). Home buyers who want to borrow more than 80 percent need to buy insurance to protect the agencies, or another party must provide it for them.”

Let me be clear: I do not want to discourage responsible home ownership—particularly for first-time buyers—but this story leaves me with one important question: Have we developed an acute case of collective amnesia?

I would caution all buyers to take advantage of low rates but not stretch beyond their comfort level–especially if they don’t have a large emergency fund or equity elsewhere to cushion them from financial or economic turmoil.